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From the beginning, the OECD's project on Base Erosion and Profit Shifting (“BEPS”)
has focused on eliminating so-called “stateless income”
(also referred to as “nowhere income” or “double non-taxation”). While that catchy phrase helped the Organization for Economic Cooperation and Development
justify support for its BEPS project and has some intuitive connotations, there is
not a commonly understood definition of the term. But more importantly, the final
rules for country-by-country (“CbC”)
reporting from both the OECD and the IRS define the term in a way that is counterintuitive
and will require U.S. multinational enterprises
(“MNEs”) to report significant amounts of “stateless income” that is actually currently
subject to tax and thus not “stateless”
under any reasonable definition of that term.

Defining ‘Stateless Income’

It appears that “stateless income”
entered the vocabulary of tax practitioners on a widespread basis around the world
in 2011 — shortly before the OECD's 2013 announcement of its BEPS project, when that
acronym also became ubiquitous and the justification for a seemingly endless variety
of tax rule changes around the world, most of which appear to be targeted at raising
foreign taxes on U.S. MNEs. In 2011, University of Southern California Gould School
of Law professor Edward Kleinbard defined “stateless income” as:

income derived by a multinational group from business activities in a country other
than the domicile (however defined)
of the group's ultimate parent company, but which is subject to tax only in a jurisdiction
that is not the location of the customers or the factors of production through which
the income was derived, and is not the domicile of the group's parent company.

So it might seem that “stateless income” should have some sort of “statelessness”
component to it. That is, like a stateless person who does not have the nationality
of any country, “stateless income” seems like it should represent income which calls
no country home, and thereby escapes taxation because each nation with a claim to
tax it considers that it belongs to another country. However, “statelessness”
is not really the motivating concern behind the pejorative connotation of the term.
Instead, it is the fact that a country other than the domicile of the MNE group's
ultimate parent company is willing to claim it as its own without actually taxing
it, or taxing it at an “inappropriately”
low rate. Thus, the imprecision in the definition of the term “stateless income” may
be part of its attractiveness; it sounds worse than what it really is. Much like describing
a country as a “tax haven,” the term “stateless income” can be asserted any time the
user of the term considers that a country imposes an insufficient level of taxation
on income within its jurisdiction. Characterization of income as “stateless” is thus
inextricably intertwined with arguments against tax competition.

Use of CbC Reporting to Identify ‘Stateless Income’

In an earlier commentary, I noted that, although one of the purposes of CbC reporting is to help tax authorities
assess transfer pricing risk, it could be useful for that purpose only in a system
where transfer pricing rules are based on formulary apportionment, rather than the
current rules based on the arm's-length standard. CbC reporting is also supposed to
assist in identifying “stateless income.”
However, the way in which “stateless income” is actually defined for purposes of CbC
reporting means that there will be no correlation between the existence of “stateless
income”
under any reasonable definition of that term and the reporting of “stateless income”
on the CbC report.

Both the final IRS regulations on CbC reporting and the Final Action 13 Report from
the OECD require the reporting of aggregate information for all “constituent entities”
for each jurisdiction in which an MNE operates, broken out to correspond to certain
purported “indicators of economic activity” (including, for example, related- and
unrelated-party revenues, profits before tax, tax paid, number of employees, and tangible
assets). The nine data points constituting these indicators of economic activity are
to be reported for each tax jurisdiction in which one or more constituent entities
of an MNE group is resident, and presented as an aggregate of the information for
the constituent entities resident in each tax jurisdiction. A business entity is considered
to be resident in a tax jurisdiction if, under the laws of that tax jurisdiction,
the business entity is “liable to tax” therein based on place of management, place
of organization, or another similar criterion.

Additionally, business entities with no tax jurisdiction of residence must be reported
on a separate line of the CbC report for “stateless entities.”
But such “stateless entities” are defined simply as those business entities treated
as transparent for tax purposes in the jurisdiction in which organized. In other words,
any entity treated as a partnership in the jurisdiction in which it is organized will
be reported as a “stateless entity” and all of its income correspondingly reported
as “stateless income.”

No explanation has been provided by either the IRS or the OECD as to why simply having
a business entity treated as transparent in its local jurisdiction should result in
a requirement to report “stateless income” on the CbC report, if “stateless income”
is supposed to have the intuitive definition of income not taxed anywhere, or income
taxed at a very low rate. The preamble to the final IRS CbC regulations explicitly
states that “[t]his rule applies irrespective of whether the stateless entity owner
is liable to tax on its share of the stateless entity's income in the owner's tax
jurisdiction of residence.”

A simple example demonstrates how this rule can give absurd results. Assume partnership
P is treated as transparent in its jurisdiction of organization, country Y, and that
it does not create a permanent establishment (“PE”)
for itself or its partners in any country. P is owned by a U.S. corporation with a
75% ownership interest and a CFC of that corporation organized in country X. Even
though the $100 of income of partnership P will flow up to the U.S. corporation and
the controlled foreign corporation and be included in their income and currently subject
to tax at significant rates, that $100 must be reported as “stateless” in the CbC
report.

To compound this absurd result, both the final IRS CbC regulations and the Final Action
13 Report from the OECD also require that each stateless entity-owner's (i.e., the
partners) share of the revenue and profit of its stateless entity is also included
in the information for the tax jurisdiction of residence of the stateless entity-owner. Thus, in this example, in addition to $100 being reported as “stateless,” $75 of
income would also be reported in the U.S. and $25 would be reported in country X.
This “double counting” of CbC data points is an intentional feature of CbC reporting,
and not a design flaw. No explanation is provided either by the IRS or the OECD how income can be both stateless
and subject to tax in another jurisdiction at the same time.

Examples like this raise serious questions as to whether there are any legitimate
tax policy concerns for imposing CbC reporting requirements on a broad swath of the
business community, along with the expensive and time-consuming compliance burden
it entails. CbC reporting was included in the OECD's BEPS project as part of the push
for more transparency and disclosure from taxpayers. As an intuitive matter it is hard to argue against more transparency to combat BEPS
concerns. But transparency also includes a relevance component; collection and disclosure
of irrelevant information is pointless.

On that test, CbC reporting fails — it is not only not a good indicator of “stateless
income,” it requires the reporting of “stateless income”
when none exists under any reasonable definition of the term. And as I noted earlier,
no explanation has yet been proffered as to how CbC reporting assists in assessing
transfer pricing risk under the arm's-length standard. It appears to be the accumulation
of a welter of data with no clear purpose, other than to comply with regulatory requirements.

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